**UNITED STATES SECURITIES AND EXCHANGE COMMISSION****WASHINGTON,D.C. 20549**

 

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# **FORM10-Q**

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# ****

# ** **

 

ý   **QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004**

 

**OR**

 

o   **TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE TRANSITION PERIOD FROM         TO         .**

 

# **COMMISSIONFILE NO. 000-31519**

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# **CURONMEDICAL, INC.**(Exact nameof registrant as specified in its charter) 

# ** **

| **Delaware**                                                    |   | **77-0470324**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |
| **46117 Landing Parkway**                                       |
| **Fremont, CA 94538**                                           |
| (Address of principal executive offices, including zip code)    |
|                                                            |
| **(510) 661-1800**                                              |
| (Registrant’s telephone number, including area code)       |

 

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Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports) and (2) has been subject to such filingrequirements for the past 90 days. YesýNo  o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act). Yes o No ý

 

Asof May 4, 2004, 24,419,849****sharesof the Registrant’s Common Stock were outstanding. 

 

 

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# **CURONMEDICAL, INC.**

# **INDEX**

# ** **

|           |                       | **Page**                                                                                                         |
|----------------|----------------------------|------------------------------------------------------------------------------------------------------------------|
| **PART  I.**   | **FINANCIAL  INFORMATION** |                                                                                                             |
|           |                       |                                                                                                             |   |
|           | Item 1.                    | Financial  Statements (unaudited)                                                                                |   |
|           |                       |                                                                                                             |   |
|           |                       | Condensed Consolidated Balance Sheets as of  March 31, 2004 and December 31, 2003                      | 3 |
|           |                       |                                                                                                             |   |
|           |                       | Condensed  Consolidated Statements of Operations for the three month periods ended  March 31, 2004 and 2003 | 4 |
|           |                       |                                                                                                             |   |
|           |                       | Condensed  Consolidated Statements of Cash Flows for the three month periods ended  March 31, 2004 and 2003 | 5 |
|           |                       |                                                                                                             |   |
|           |                       | Notes  to Condensed Consolidated Financial Statements                                                            | 6 |
|           |                       |                                                                                                             |   |
|           | Item  2.                   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                      | 11 |
|           |                       |                                                                                                             |   |
|           | Item  3.                   | Quantitative  and Qualitative Disclosures of Market Risk                                                         | 23 |
|           |                       |                                                                                                             |   |
|           | Item 4.                    | Controls  and Procedures                                                                                         | 23 |
|           |                       |                                                                                                             |   |
| **PART  II.**  | **OTHER  INFORMATION**     |                                                                                                             |
|           |                       |                                                                                                             |   |
|           | Item 1.                    | Legal  Proceedings                                                                                               | 23 |
|           |                       |                                                                                                             |   |
|           | Item  6.                   | Exhibits  and Reports on Form 8-K                                                                                | 25 |
|           |                       |                                                                                                             |   |
| **SIGNATURES** | 26                         |
|                |                            |                                                                                                                  |  |  |

 

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**PARTI    FINANCIAL INFORMATION****Item 1.  Financial Statements**

 

**CURON MEDICAL, INC.**

CondensedConsolidated Balance Sheets

(Unaudited, in thousands)

 
|                                            |   | **March 31,  2004** |   | **December 31,  2003** |   |
|-------------------------------------------------|--------|--------------------------|--------|-----------------------------|--------|
| **Assets**                                      |   |                     |   |                        |   |
| Current assets:                                 |   |                     |   |                        |   |
| Cash and cash equivalents                       |   | $                        | 2,544  |                        | $      | 4,865 |   |
| Marketable securities                           |   | 15,361                   |   | 5,269                       |   |
| Accounts receivable, net                        |   | 743                      |   | 834                         |   |
| Inventories, net                                |   | 1,289                    |   | 1,063                       |   |
| Prepaid expenses and other current assets       |   | 805                      |   | 863                         |   |
| Total current assets                            |   | 20,742                   |   | 12,894                      |   |
|                                            |   |                     |   |                        |   |
| Property and equipment, net                     |   | 831                      |   | 836                         |   |
| Other assets                                    |   | 121                      |   | 124                         |   |
| Total assets                                    |   | $                        | 21,694 |                        | $      | 13,854 |   |
|                                            |   |                     |   |                        |   |
| **Liabilities and  Stockholders’ Equity**  |   |                     |   |                        |   |
| Current liabilities:                            |   |                     |   |                        |   |
| Accounts payable                                |   | $                        | 506    |                        | $      | 517 |   |
| Accrued liabilities                             |   | 1,339                    |   | 1,164                       |   |
| Litigation reserve                              |   | —                   |   | 1,250                       |   |
| Total current liabilities                       |   | 1,845                    |   | 2,931                       |   |
|                                            |   |                     |   |                        |   |
| Other liabilities                               |   | 161                      |   | 115                         |   |
| Total liabilities                               |   | 2,006                    |   | 3,046                       |   |
|                                            |   |                     |   |                        |   |
| Contingencies (Note 4)                          |   | —                   |   | —                      |   |
|                                            |   |                     |   |                        |   |
| Stockholders’ equity:                      |   |                     |   |                        |   |
| Common stock                                    |   | 24                       |   | 20                          |   |
| Additional paid-in capital                      |   | 103,144                  |   | 90,314                      |   |
| Deferred stock compensation                     |   | —                   |   | (4                          | )      |
| Accumulated deficit                             |   | (83,227                  | )      | (79,287                     | )      |
| Treasury stock                                  |   | (234                     | )      | (234                        | )      |
| Accumulated other comprehensive income          |   | (19                      | )      | (1                          | )      |
| Total stockholders’ equity                 |   | 19,688                   |   | 10,808                      |   |
|                                            |   |                     |   |                        |   |
| Total liabilities and stockholders’ equity |   | $                        | 21,694 |                        | $      | 13,854 |   |

 

See accompanying notes to condensed consolidated financial statements

 

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**CURONMEDICAL, INC.**

Condensed ConsolidatedStatements of Operations

(Unaudited)

(in thousands, except pershare amounts)

 
|                                                            |   | **For the  Three Months Ended** |   |
|-----------------------------------------------------------------|--------|---------------------------------|--------|
|                                                            |   | **March 31,  2004**        |   | **March 31,  2003** |   |
|                                                            |   |                            |   |   |   |
| Revenues                                                        |   | $                               | 1,009  |   | $ | 709 |   |
| Cost of goods sold                                              |   | 1,070                           |   | 983 |   |
|                                                            |   |                            |   |   |   |
| Gross loss                                                      |   | (61                             | )      | (274 | ) |
|                                                            |   |                            |   |   |   |
| Operating expenses:                                             |   |                            |   |   |   |
| Research and development                                        |   | 497                             |   | 453 |   |
| Clinical and regulatory                                         |   | 353                             |   | 315 |   |
| Sales and marketing                                             |   | 2,069                           |   | 1,402 |   |
| General and administrative                                      |   | 985                             |   | 920 |   |
|                                                            |   |                            |   |   |   |
| Total operating expenses                                        |   | 3,904                           |   | 3,090 |   |
|                                                            |   |                            |   |   |   |
| Operating loss                                                  |   | (3,965                          | )      | (3,364 | ) |
|                                                            |   |                            |   |   |   |
| Interest income                                                 |   | 39                              |   | 95 |   |
| Other income (expense), net                                     |   | (14                             | )      | 4 |   |
|                                                            |   |                            |   |   |   |
| Net loss                                                        |   | $                               | (3,940 | ) | $ | (3,265 | ) |
|                                                            |   |                            |   |   |   |
| Net loss per share, basic and diluted                           |   | $                               | (0.17  | ) | $ | (0.16 | ) |
|                                                            |   |                            |   |   |   |
| Shares used in computing net loss per  share, basic and diluted |   | 22,659                          |   | 19,977 |   |

 

See accompanying notes to condensed consolidated financial statements

 

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**CURON MEDICAL, INC.**

Condensed Consolidated Statements of Cash Flows

(Unaudited, in thousands)

 
|                                                                         |   | **For the  Three Months Ended,** |   |
|------------------------------------------------------------------------------|--------|----------------------------------|--------|
|                                                                         |   | **March 31,  2004**         |   | **March 31,  2003** |   |
| **Cash Flows From  Operating Activities**                                    |   |                             |   |   |   |
| Net loss                                                                     |   | $                                | (3,940 | ) | $ | (3,265 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |   |                             |   |   |   |
| Payment of litigation settlement                                             |   | (1,250                           | )      | — |   |
| Depreciation and amortization                                                |   | 118                              |   | 136 |   |
| Stock-based compensation                                                     |   | 31                               |   | 44 |   |
| (Gain)/loss on sale of property and  equipment                               |   | 3                                |   | (6 | ) |
| Amortization of premium on securities, net                                   |   | 100                              |   | 83 |   |
| Changes in assets and liabilities:                                           |   |                             |   |   |   |
| Accounts receivable, net                                                     |   | 91                               |   | 252 |   |
| Inventories, net                                                             |   | (226                             | )      | 48 |   |
| Prepaid expenses and other current assets                                    |   | 58                               |   | 38 |   |
| Accounts payable                                                             |   | (11                              | )      | (19 | ) |
| Accrued liabilities                                                          |   | 175                              |   | 189 |   |
| Other long-term assets and liabilities                                       |   | 49                               |   | (3 | ) |
| Net cash used in operating activities                                        |   | (4,802                           | )      | (2,503 | ) |
|                                                                         |   |                             |   |   |   |
| **Cash Flows From  Investing Activities**                                    |   |                             |   |   |   |
| Purchase of property and equipment                                           |   | (116                             | )      | (57 | ) |
| Sale of property and equipment                                               |   | —                           |   | 6 |   |
| Purchase of marketable securities                                            |   | (11,960                          | )      | (3,101 | ) |
| Proceeds from maturities of marketable  securities                           |   | 1,750                            |   | 6,660 |   |
| Net cash provided by (used in) investing  activities                         |   | (10,326                          | )      | 3,508 |   |
|                                                                         |   |                             |   |   |   |
| **Cash Flows From  Financing Activities**                                    |   |                             |   |   |   |
| Proceeds from issuance of common stock, net                                  |   | 12,690                           |   | — |   |
| Proceeds from sale of stock options                                          |   | 117                              |   | — |   |
| Principal payments on notes payable                                          |   | —                           |   | (42 | ) |
| Net cash provided by (used in) financing  activities                         |   | 12,807                           |   | (42 | ) |
| Net increase (decrease) in cash and cash  equivalents                        |   | (2,321                           | )      | 963 |   |
| Cash and cash equivalents at beginning of  period                            |   | 4,865                            |   | 8,570 |   |
| Cash and cash equivalents at end of period                                   |   | $                                | 2,544  |   | $ | 9,533 |   |

 

See accompanying notes to the condensed consolidated financialstatements

 

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# **CURONMEDICAL, INC.NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS(Unaudited, tabular amounts in thousands, except per share data)**

# ** **

**March 31,2004**

 

**NOTE1.   The Company and Summary of Significant Accounting Policies**

 

**The Company**

 

Curon Medical, Inc. (the“Company”) was incorporated in the State of Delaware on May 1, 1997. TheCompany develops, manufactures and markets proprietary products for thetreatment of gastrointestinal disorders. 

 

The Company has sustainedoperating losses and negative cash flows from operations and expects suchlosses to continue in the foreseeable future. The Company intends to financeits operations primarily through its cash and cash equivalents, revenues,marketable securities, and financing activities.  Management believes the Company currently has enough cash to fundoperations for at least the next twelve months.  Should additional funding be required at any point in the future,alternative financing will be sought from various possible sources, includingthe public equity market, private financings, collaborative arrangements anddebt. If additional capital is raised through the issuance of equity orsecurities convertible into equity, stockholders will experience dilution, andsuch securities may have rights, preferences or privileges senior to those ofthe holders of common stock. There can be no assurance that the Company will beable to obtain such financing, or to obtain it on acceptable terms.  If the Company is unable to raise additionalfunds, operations will need to be substantially reduced in order to conserveworking capital.

 

**Basis ofPresentation**

 

The condensed consolidatedfinancial statements include the accounts of the Company and its wholly ownedsubsidiaries after elimination of all intercompany balances and transactions. 

 

The accompanying unauditedcondensed consolidated financial statements have been prepared by the Companyin accordance with accounting principles generally accepted in the UnitedStates of America for interim financial information and pursuant to theinstructions to Form 10-Q and Article 10 of Regulation S-X promulgated bythe Securities and Exchange Commission (“SEC”). Accordingly, they do notinclude all of the information and footnotes required by generally acceptedaccounting principles for complete financial statements. The unaudited interimcondensed consolidated financial statements have been prepared on the samebasis as the annual consolidated financial statements and, in the opinion ofmanagement, contain all adjustments (all of which are normal and recurring innature) necessary to present fairly the financial position, results of operationsand cash flows of the Company for the periods indicated. Interim results ofoperations are not necessarily indicative of the results to be expected for thefull year or any other interim periods. 

 

These condensed consolidatedfinancial statements should be read in conjunction with the audited financialstatements included in the Annual Report on Form 10-K for the year endedDecember 31, 2003, as filed with the SEC.

 

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**Net LossPer Share**

 

Basic and diluted net lossper share is calculated as follows:
|                                                                  |   | **Three  Months Ended March 31,** |   |
|-----------------------------------------------------------------------|--------|----------------------------------------|--------|
|                                                                  |   | **2004**                               |   | **2003** |   |
| Numerator:                                                            |   |                                   |   |   |   |
| Net loss                                                              |   | $                                      | (3,940 | ) | $ | (3,265 | ) |
|                                                                  |   |                                   |   |   |   |
| Denominator:                                                          |   |                                   |   |   |   |
| Weighted average shares outstanding                                   |   | 22,659                                 |   | 19,994 |   |
|                                                                  |   |                                   |   |   |   |
| Weighted average unvested common shares  subject to repurchase        |   | —                                 |   | (17 | ) |
|                                                                  |   |                                   |   |   |   |
| Weighted average shares used in basic and  diluted net loss per share |   | 22,659                                 |   | 19,977 |   |
|                                                                  |   |                                   |   |   |   |
| Net loss per share                                                    |   | $                                      | (0.17  | ) | $ | (0.16 | ) |

 

During 1999, the Companygranted to certain employees and non-employees, options which were immediatelyexercisable into common stock, subject to repurchase by the Company untilvested. Shares are subject to repurchase at the original option exercise price.

 

Equity instruments thatcould dilute basic earnings per share in the future, that were not included inthe computation of diluted earnings per share as their effect is antidilutive,are as follows: 

 

|                                                   |   | **March 31,  2004** |   | **March 31,  2003** |   |
|--------------------------------------------------------|--------|--------------------------|--------|--------------------------|--------|
| Unvested common shares (shares subject to  repurchase) |   | —                   |   | 15                       |   |
| Shares issuable through ESPP                           |   | 89                       |   | 80                       |   |
| Shares issuable upon exercise of stock  options        |   | 3,621                    |   | 3,116                    |   |
| Shares issuable upon exercise of warrants              |   | 1,475                    |   | 569                      |   |
|                                                   |   |                     |   |                     |   |
| Total                                                  |   | 5,185                    |   | 3,780                    |   |

 

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**Stock BasedCompensation**

 

The Company accounts for itsstock-based compensation using the method prescribed by APB No. 25. Had theCompany determined its stock-based compensation based on the fair value at thegrant dates for the awards under a method prescribed by SFAS No. 123, theCompany’s net loss would have been increased to the FAS 123 (as amended by SFASNo. 148) adjusted amounts indicated below:

 
|                                                                                                                    |   | **Quarter  Ended March 31,** |   |
|-------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                                                                    |   | **2004**                          |   | **2003** |   |
|                                                                                                                    |   |                              |   |   |   |
| Net loss, as reported                                                                                                   |   | $                                 | (3,940 | ) | $ | (3,265 | ) |
| Add:  Stock-based employee compensation expense in reported net loss                                               |   | 4                                 |   | 44 |   |
| Deduct:   Total stock-based employee compensation expense determined under fair  value based method for all awards |   | (146                              | )      | (315 | ) |
| Net loss - FAS 123 adjusted                                                                                             |   | $                                 | (4,082 | ) | $ | (3,536 | ) |
| Net loss per share - as reported  Basic and diluted                                                                     |   | $                                 | (0.17  | ) | $ | (0.16 | ) |
| Net loss per share - FAS 123 adjusted  Basic and diluted                                                                |   | $                                 | (0.18  | ) | $ | (0.18 | ) |

 

**ProductWarranty**

 

The Company generallywarrants its capital equipment products against defects for a period of oneyear and records a liability for such product warranty obligations at the timeof sale based upon historical experience. The Company also sells separately priced extended warranties to provideadditional warranty coverage and recognizes the related revenue on astraight-line basis over the extended warranty period, which is generally oneto four years.  Costs associated withservices performed under the extended warranty obligation are expensed asincurred.

 

Changes in product warrantyobligations, including separately priced extended warranty obligations, for thethree months ended March 31, 2004 and 2003 are as follows:

 
|                                                                      |   | **2004** |   | **2003** |   |
|---------------------------------------------------------------------------|--------|----------|--------|----------|--------|
| Balance as of the beginning of the year                                   |   | $        | 58     |     | $      | 44 |   |
| Add:                                                                      |   |     |   |     |   |
| Accruals for warranties issued                                            |   | 5        |   | 4        |   |
| Revenue recognized under separately priced  extended warranty obligations |   | (3       | )      | (2       | )      |
| Balance as of the end of the year                                         |   | $        | 60     |     | $      | 46 |   |

 

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**NOTE2.   Inventories**

 
|                   |   | **March 31,  2004** |   | **December 31,  2003** |   |
|------------------------|--------|--------------------------|--------|-----------------------------|--------|
| Inventories:           |   |                     |   |                        |   |
| Raw material           |   | $                        | 686    |                        | $      | 712 |   |
| Work-in-process        |   | 98                       |   | 89                          |   |
| Finished goods         |   | 505                      |   | 262                         |   |
|                   |   |                     |   |                        |   |
| Total inventories, net |   | $                        | 1,289  |                        | $      | 1,063 |   |

 

 

**NOTE3.   Deferred Stock Compensation**

 

Stock-based compensationincluded in the Condensed Consolidated Statements of Operations is as follows: 

 
|                       |   | **Three  Months Ended March 31,** |   |
|----------------------------|--------|----------------------------------------|--------|
|                       |   | **2004**                               |   | **2003** |   |
|                       |   |                                   |   |   |   |
| Cost of goods sold         |   | $                                      | — |   | $ | 5 |   |
| Research and development   |   | 1                                      |   | 12 |   |
| Clinical and regulatory    |   | 26                                     |   | 6 |   |
| Sales and marketing        |   | 4                                      |   | 17 |   |
| General and administrative |   | —                                 |   | 4 |   |
|                       |   |                                   |   |   |   |
|                       |   | $                                      | 31     |   | $ | 44 |   |

 

**NOTE4.   Contingencies**

 

In June 2001, a civilaction was filed against the Company in the United States District Court,Western District of Kentucky, Louisville Division, alleging that the Plaintiffsustained a vagal nerve injury and damage to his gastrointestinal tract duringa Stretta Procedure caused by the defective design and manufacture of theCompany’s product. Plaintiff’s claims against the Company include strictliability for a product  alleged to be ina defective and unreasonably dangerous condition, negligence in the design andmanufacturing of the product, breach of implied warranty of merchantability,and loss of consortium. Plaintiff was a subject in a randomized clinical trialand had been provided with an approved Informed Consent form and counseling bythe physician. Prior to treatment, the subject provided consent to proceed.Plaintiff is seeking a trial by jury and unspecified damages. This matter isstill in the discovery, document production and deposition stage.  The trial date has been postponed and iscurrently scheduled to commence in February 2005. The Company believesPlaintiff’s claims are without merit. The Company believes that the resolutionof this matter will not have a material effect, if any, on its business,financial position, results of operations and cash flows.

 

In June 2002, a civilaction was filed against a number of defendants, including the Company, in theCourt of Common Pleas, Philadelphia County, in the State of Pennsylvania,alleging that the Plaintiff sustained injury during a clinical trial for theSecca device caused by the device being defective and/or in an unreasonablydangerous condition. The Company has settled the case, resulting in a paymentto Plaintiff in March 2004 of $1.25 million.  This amount had been reserved at December 31, 2003.

 

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In April 2003, a civilaction was filed against the Company in United States District Court for theNorthern District of California by Federal Insurance Corporation, the Company’sinsurance carrier, for rescission, reformation, and restitution in connectionwith the Company’s liability insurance policy. This policy covers, among otherthings, product liability claims made against the Company by people treatedwith the Company’s product.  There is asummary judgment motion scheduled for July 29, 2004 in this matter. Shouldthe Company lose this motion, there will be no coverage in the Pennsylvaniasuit described above and the payment of the $1.25 million will be the limit ofthe Company’s liability in this case. Should the Company win the motion, the $1.25 million may be reimbursed.If coverage is rescinded, any lawsuits filed arising out of any occurrencesbetween May 22, 2002 and May 21, 2003 would not be covered by liabilityinsurance.  The Company is not aware ofany incident occurring in that time period that is believed would lead to alawsuit.  

 

**NOTE5.   Issuance of Common Stock and Warrants**

 

On February 6, 2004,the Company raised approximately $13.5 million in gross proceeds from theprivate placement of common stock and warrants to several institutionalinvestors.  Net proceeds to the Companyafter estimated offering costs and expenses were approximately $12.7 million.  The transaction involved the sale of4,025,000 newly issued shares of the Company’s common stock at a price of $3.36per share and warrants to purchase an aggregate of 905,625 shares of commonstock an exercise price of $4.71 per share.  The common stock warrants have a five-year term and become exercisableon August 6, 2004.  The aggregatevalue of the common stock warrants was determined to be a part of the $13.5million purchase price and has been classified within additional paid-incapital.  In addition, on or afterAugust 6, 2007, should the Company’s stock price close at or above 175% ofthe exercise price on any 15 out of 30 consecutive trading days, and othercertain conditions are met as defined in the warrant agreement, the Company hasthe right, on one occasion, to require the holders of the common stock warrantsto exercise such common stock warrants. The Company has determined the value of this right to be immaterial. Thesale of the securities was deemed exempt from registration under the SecuritiesAct in reliance upon Regulation D promulgated under the Securities Act.  The Company used the proceeds to purchasemarketable securities in the form of commercial paper.

 

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**Item 2.  Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

 

The following discussionshould be read in conjunction with the attached financial statements and notesthereto, and with our audited financial statements and notes thereto for thefiscal year ended December 31, 2003. 

 

This quarterly report,including the following sections, contains forward-looking statements withinthe meaning of the Private Securities Litigation Reform Act of 1995. Thesestatements include statements relating to our expectations as to the rates ofmarket adoption of our products, the timing and effect on market adoption ofreimbursement approvals, the timing and extent of technical improvements to ourproducts, and our ability to achieve higher sales volume for this fiscal year.These forward-looking statements involve risks and uncertainties. Thecautionary statements set forth below and those contained in “Factors That MayAffect Future Results,” commencing on page 15*,*identify important factors that could cause actual results to differ materiallyfrom those predicted in any such forward-looking statements. 

 

**Overview**

 

We wereincorporated in May 1997. Business activities before January 1998were negligible. Prior to December 31, 2000, we were in the developmentstage and until that time, we had devoted substantially all of our efforts toraising capital and developing our products. 

 

In 1998, our primary activity was developing the Curon Control Moduleand Stretta Catheter for the treatment of gastroesophageal reflux disease, orGERD. In October 1999, we received CE Mark approval of the Stretta System,indicating that the Stretta System meets European Medical Device Directive, orMDD, standards allowing us to market it within the European Union. We received510(k) clearance from the FDA in April 2000 and commercially launched inthe United States in May 2000. 

 

In April 1999, webegan developing our second set of products, the Secca System, for thetreatment of fecal incontinence. In November 1999, we conducted a10-patient human clinical pilot study outside the United States and, inJuly 2000, we began a U.S. multi-center clinical trial of the Secca Systemunder an Investigational Device Exemption. In September 2001, we receivedCE Mark approval of the Secca System, indicating that the Secca System meetsEuropean medical device standards, allowing us to market it within the EuropeanUnion. Our multi-center clinical trial was completed, and the results were usedto support a 510(k) submission to the FDA in December 2001. We received510(k) clearance from the FDA in March 2002 to market the system for thetreatment of fecal incontinence in patients who have failed more conservativetherapies such as diet modification and biofeedback. We made our first sales ofthe Secca System in June 2002. 

 

We market the StrettaSystem, as an alternative to anti-reflux surgery, primarily to high volumegastroenterologists and general surgeons who actively perform endoscopy.  In the United States, we estimate that thereare approximately 4,000 general surgeons and 9,000 gastroenterologists whoactively perform endoscopy.  We marketthe Secca System primarily to colon and rectal surgeons and to those generalsurgeons who perform colorectal surgery. We estimate that there are approximately 1,000 colon and rectal surgeonsand approximately 2,000 general surgeons who perform colorectal surgery in theUnited States.

 

We are focusing our salesefforts in the United States through a direct sales force, supplemented byselected manufacturing representatives. In international markets, we relyprimarily on third-party distributors. In November 2000, we incorporated asubsidiary company in Belgium to support European distributors’ sales,marketing and clinical efforts. As of March 31, 2004, this subsidiary hadtwo employees. To date, we have international distribution agreements for theStretta System in 17 European and Middle Eastern countries and in South Africa.The Secca System will also be sold through distributors in Europe, and the firstcommercial European Secca procedure was performed in March 2003. Our grossmargins on sales through

 

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international third-partydistributors will be lower than our gross margins on U.S. sales as a result ofdistributor discounts. 

 

Inthe United States, health care providers generally rely upon third-partypayers, principally private health insurance plans, but also Medicare andMedicaid, to reimburse all or part of the cost of procedures in which medicaldevices are used. In general, these procedures are reimbursed in two parts atrates established by the various payers. The first part pays the hospital orsimilar institution for the use of their staff, facilities and the cost of thedevice that we supply. For procedures like the ones in which our products areused, Medicare uses a system based on the use of the appropriate CMS (Medicare)Ambulatory Procedure Coding, or APC, to determine facility reimbursementlevels. This code values the Stretta procedure at $1,850. Private insurers willset their own reimbursement levels that typically are higher than the Medicarelevel. For the Secca procedure, we have received written notification from CMSthat an APC for this procedure will be published on July 1, 2004. Theamount allocated to this code will not be known until publication. 

 

The second part pays thefees of the physician performing the procedure. If the American MedicalAssociation, or AMA, has established a Category I Current ProceduralTerminology code, or CPT code, with associated relative value units for aprocedure, those relative value units are used by Medicare to set reimbursementlevels. Private insurers will set their own reimbursement levels that typicallyare higher than the Medicare level. Until a Category I CPT code is established,the reimbursement levels for physicians are set individually by the variouscarriers.

 

Currently, the Strettaprocedure has a Category III CPT code assigned to it that does not specifyrelative values. On January 1, 2005, the Stretta procedure will have aCategory I CPT coding with relative value units assigned. The amount of thesewill not be known until final publication of the Category I code inNovember 2004. The Secca procedure has not yet been assigned a CPT code bythe AMA nor have any relative value units been assigned for the performance ofthe procedure.

 

To date, we have generatedlimited revenues. Our revenues are, and will be, derived from the sale of ourdisposable devices, such as the Stretta Catheter and Secca Handpiece, and ourradiofrequency generators. We expect that disposable sales will continue toform the basis of a recurring revenue stream. However, domestic disposablesales continue to grow more slowly than expected primarily due to difficultiesencountered by our physician customers in obtaining reimbursement for theStretta procedure on a case-by-case basis. Some of our customers also find the45 minutes necessary to perform a Stretta procedure to be too time-consuming,as their endoscopy unit schedule is typically dominated by shortdiagnostic procedures. Our strategies are designed to address these concerns bypursuing state and national reimbursement coverage, focusing on entrenching thetherapy to promote repeat catheter sales, and incorporating technicalimprovements to our systems to reduce treatment times. 

 

**RESULTS OFOPERATIONS**

 

**Periods ofthree months ended March 31, 2004 and 2003.**

 

***Revenues***

 

Revenues for the quarterended March 31, 2004 were $1,009,000, compared to $709,000 for the samequarter in 2003. Stretta System products accounted for 92% and Secca Systemproducts accounted for 8% of the quarter’s revenues, In the first quarter of2003, Stretta System products accounted for 89%, and Secca System products were11% of the quarter’s revenues. The Stretta Control Module and Catheteraccounted for 43% and 53%, respectively, of the Stretta product line sales forthe quarter ended March 31, 2004, compared to 40% and 57%, respectively,for the same period in 2003. International sales accounted for $9,000 in thequarter ended March 31, 2004, compared to $69,000 in the same quarter of2003, with the decrease related to difficulties in obtaining reimbursementinternationally.

 

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***Cost of goods sold***

 

Our costs of goods soldrepresent the cost of producing generators and disposable devices.  We also license a technology used in thegenerators we sell, and are required to pay licensing fees based on the salesprice of the units.  We believe thatthere are alternative technologies that could be utilized should we choose todo so.  Cost of goods sold was $1.1million in the quarter ended March 31, 2004, and  $983,000 for the same period in 2003.  Our sales have not yet reached a level that would absorb ourmanufacturing capacity to the extent that we would experience positive grossprofit. 

 

***Research and development expenses***

 

Research and developmentexpenses consist primarily of personnel costs, professional services, animalstudies, patent application and maintenance costs, materials, supplies andequipment.  Research and developmentexpenses were $497,000 in the quarter ended March 31, 2004, and $453,000for the same period in 2003.  Theincrease represents increased spending on patents.

 

***Clinical and regulatory expenses***

 

Clinical and regulatoryexpenses consist primarily of expenses associated with the costs of clinicaltrials, clinical support personnel, the collection and analysis of the resultsof these trials, and the costs of submission of the results to regulatoryagencies.  Clinical and regulatoryexpenses were $353,000 in the quarter ended March 31, 2004, and $315,000for the same period in 2003.  The increasemainly represents increased patient enrollment in our Secca randomized clinicaltrial.

 

***Sales and marketing expenses***

 

Sales and marketing expensesconsist of personnel related costs, advertising, public relations andattendance at selected medical conferences. Sales and marketing expenses were$2.1 million in the quarter ended March 31, 2004, and $1.4 million for thesame period in 2003.  Higher spending isrelated to increased headcount in the sales and marketing departments, as wellas related increases in spending for travel and marketing expense.  Headcount and spending has increased as weposition our sales, marketing and reimbursement teams for projected increasedsales volumes.  

 

***General and administrative expenses***

 

General and administrativeexpenses consist primarily of the cost of corporate operations and personnel,legal, accounting and other general operating expenses of our company. Generaland administrative expenses were $985,000 in the quarter ended March 31,2004, and $920,000 for the same period in 2003. Higher spending is related toan increase in insurance rates, legal spending, and investor relations. 

 

***Interest Income, net***

 

During the quarter endedMarch 31, 2004, compared to the quarter ended March 31, 2003, netinterest income decreased by $56,000. The decrease was due to an average cashand investment decrease of approximately $7.0 million, and a decrease ininvestment yields from approximately 1.5% to 1.3%. Interest expense was notmaterial for any period presented. 

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

At March 31, 2004, wehad $18.9 million in working capital and our primary source of liquidity was$17.9 million in cash and cash equivalents and marketable securities, comparedto $10.0 million and $10.1 million, respectively, as of December 31,2003.  Our cash, cash equivalents, andworking capital have increased due to the proceeds from our private placementfinancing in February 2004. We intend to finance

 

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our operations primarilythrough our cash and cash equivalents, revenues, marketable securities, andfinancing activities. We believe, if our revenues increase and we maintain ourcontrol over operating costs, we have enough cash to fund operations for atleast twelve months, and that alternative financing is available, if needed.However, there can be no assurance that such efforts will succeed or thatsufficient funds will be made available. If we are unable to raise additional funds, we may have to substantiallyreduce our operations to conserve working capital.

 

Cash used in operatingactivities was $4.8 million in the three month period ended March 31,2004, and $2.5 million for the same period in 2003. Our loss for the firstthree months of 2004 was $3.9 million, compared to a loss of $3.3 million forthe same period in 2003.  Increased cashuse was due to the $1.25 million paid for the settlement of a lawsuit, anincrease in inventories of $226,000, as we prepare to support the projectedhigher sales volume in the current year, and increased spending in the salesand marketing departments of $667,000, to support projected increased salesvolume.

 

Cash used in investingactivities was $10.3 million in the three months ended March 31, 2004,which consisted primarily of net purchases of marketable securities, as weinvested the cash received from our private placement financing inFebruary 2004.  As ofMarch 31, 2004, we had no material commitments for capital expenditures.For the three months ended March 31, 2003, net cash provided by investingactivities was $3.5 million, which consisted primarily of proceeds from netmaturities and sales of marketable securities.

 

Cash provided by financingactivities was $12.8 million in the three months ended March 31, 2004,related to the private placement of common stock to a group of institutionalinvestors in the net amount of $12.7 million, in addition to $117,000 fromsales of stock options. For the same period in 2003, cash used in financingactivities was $42,000, primarily related to the payoff of a note payable tofinance insurance policies.

 

We lease office, researchand development, and manufacturing space under a noncancelable operating leaseexpiring in October 2006.  Futureminimum payments under this lease are as follows:

 
| 2004                                |   | $   | 309    |   |
|-------------------------------------|--------|-----|--------|--------|
| 2005                                |   | 377 |   |
| 2006                                |   | 318 |   |
| Total future minimum lease payments |   | $   | 1,004  |   |

 

In August 2002, weannounced that our Board of Directors had authorized a stock repurchase programpermitting the purchase of up to 1,000,000 shares of our Common Stock in openmarket transactions at prices deemed appropriate by management, and administeredpursuant to Rule 10b-18 of the Securities Exchange Act of 1934. Shares have notbeen repurchased under this plan since 2002.

 

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**Factors That May Affect Future Results**

 

**We may never achieve or maintain significantrevenues or profitability.**

 

We have only a limited operating history upon which you can evaluateour business. We have incurred losses every year since we began operations. Inparticular, we incurred net losses of $15.6 million in 2003,$15.4 million in 2002, and $15.4 million in 2001 and $3.9 million forthe three months ended March 31, 2004. As of March 31, 2004, we hadan accumulated deficit of approximately $83.2 million. Our revenues are, andwill be, derived from the sale of radiofrequency generators and our disposabledevices, such as the Stretta Catheter and Secca Handpiece. We have generatedlimited revenues, and it is possible that we will never generate significantrevenue from product sales. Even if we do achieve significant revenues from ourproduct sales, we may continue to incur net losses and these losses mayincrease. It is possible that we will never achieve profitable operations. 

 

**If health care providers are not adequatelyreimbursed for the procedures, that use our products, or for the productsthemselves, we may never achieve significant revenues.**

 

Our physiciancustomers continue to encounter difficulties in easily obtaining reimbursementfor the Stretta procedure on a case-by-case basis, and this continues to impactour ability to significantly increase revenues. We may not be successful ataddressing these difficulties with our strategies of pursuing state-by-state,and also selected national, reimbursement coverage, focusing on promotingrepeat catheter sales and incorporating technical improvements to our systemsto reduce treatment times. 

 

Curon has been actively seeking, and, in instances, receiving, positivecoverage decisions from Medicare and private payers to reimburse physicians,hospitals and other health care providers for procedures using our products.There is, however, no assurance that local Medicare or private payers willchoose to pay for this procedure. Physicians, hospitals and other health careproviders are unlikely to purchase our products if they are not adequatelyreimbursed for the Stretta procedure or the products. In the last year, Curonhas received six Medicare coverage decisions covering nine states, one privatepayer national coverage decision and a number of private payer state coveragedecisions. Some payers may refuse adequate reimbursement even thoughsignificant peer-reviewed data has been published. If users of our productscannot obtain sufficient reimbursement from health care payers for the Strettaprocedure or the Stretta System disposables, then it is unlikely that ourproducts will ever achieve increased market acceptance. The Secca procedure hasnot yet received any coding decision and there is little data yet regarding thewillingness of third-party health care payers to reimburse the costs of theprocedure. We cannot assure you that the procedure will ever be reimbursed.Failure to achieve reimbursement will have a serious negative effect on ourrevenues. 

 

**Reimbursement from third-party health carepayers is uncertain due to factors beyond our control, and changes inthird-party health care payers’ policies could adversely affect our salesgrowth.**

 

Even if third-party payers provide adequate reimbursement for theStretta procedure, adverse changes in third-party payers’ policies towardreimbursement could preclude market acceptance for our products and have amaterial adverse effect on our sales and revenue growth. We are unable topredict what changes will be made in the reimbursement methods used bythird-party health care payers. 

 

For example, some health care payers are moving toward a managed caresystem in which providers contract to provide comprehensive health care for afixed cost per person. We cannot assure you that in a prospective paymentsystem, which is used in many managed care systems, the cost of our productswill be incorporated into the overall payment for the procedure or that therewill be adequate reimbursement for our products separate from reimbursement forthe procedure. 

 

Internationally, market acceptance of our products will be dependentupon the availability of adequate reimbursement within prevailing health carepayment systems. Reimbursement and health care

 

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payment systems in international markets vary significantly by countryand include both government-sponsored health care and private insurance.Although we are seeking international reimbursement approvals, we cannot assureyou that any such approvals will be obtained in a timely manner or at all. Ifforeign third-party payers do not adequately reimburse providers for theStretta procedure and the products used with it, then our sales and revenuegrowth may be limited. During the quarter ended March 31, 2004, ourinternational sales have decreased substantially to $9,000, due toreimbursement issues.

 

**If physicians do not increase rates ofadoption of our products, we will not achieve future sales growth.**

 

To achieve increasing sales, our products must continue to gainrecognition and adoption by physicians who treat gastrointestinal disorders.Our products represent a significant departure from conventional treatmentmethods. We believe that physicians will not increase rates of adoption of oursystems unless they determine, based on published peer-reviewed journalarticles, long-term clinical data and their professional experience, that oursystems provide an effective and attractive alternative to conventional meansof treatment. Currently, there are 20 peer-reviewed journal articles on the Strettaprocedure, including the results of our Stretta randomized trial, and threepeer-reviewed journal articles on the Secca procedure. Physicians aretraditionally slow to adopt new products and treatment practices, partlybecause of perceived liability risks and uncertainty of third-partyreimbursement. Future adverse events or recalls would also impact futureacceptance rates. Additionally, some of our customers and potential customersalso find the 45 minutes necessary to perform a Stretta procedure to be alimiting issue, as their endoscopy unit schedule is typically dominated byshort diagnostic procedures. If we cannot achieve increasing physician adoptionrates of our products, we may never achieve significant revenues orprofitability. 

 

**If the effectiveness and safety of ourproducts are not supported by long-term data, our sales could decline and wecould be subject to liability.**

 

If we do not produce clinical data supported by the independent effortsof clinicians, our products may never be accepted. We received clearance fromthe FDA for the use of the Stretta System to treat gastroesophageal refluxdisease, or GERD, based upon the study of 47 patients. Safety and efficacy datapresented to the FDA for the Stretta System was based on six-month follow-upstudies on 44 of these patients. Although the twelve- and thirty-three monthfollow-up data supports the six-month data, we may find that data fromlonger-term patient follow-up studies is inconsistent with those indicated byour relatively short-term data. If longer-term patient studies or clinicalexperience indicate that treatment with the Stretta System does not providepatients with sustained benefits or that treatment with our product is lesseffective or less safe than our current data suggests, our sales could declineand we could be subject to significant liability. Further, we may find that ourdata is not substantiated in studies involving more patients, in which case wemay never achieve significant revenues or profitability. 

 

We received clearance from the FDA for the use of the Secca System totreat fecal incontinence, for patients who have failed more conservativetreatments such as diet modification or biofeedback. This clearance was basedupon the study of 50 patients. Safety and efficacy data presented to the FDAfor the Secca System was based on six-month follow-up studies on thesepatients. However, if longer-term patient studies or clinical experienceindicate that treatment with the Secca System does not provide patients with sustainedbenefits or that treatment with our product is less effective or less safe thanour current data suggests, our sales could decline and we could be subject tosignificant liability. Further, we may find that our data is not substantiatedin studies involving more patients, in which case we may never achievesignificant revenues or profitability. If patient studies or clinicalexperience do not meet our expectations regarding the benefits of the SeccaSystem, our expected revenues from this product may never materialize. 

 

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**Any failure in our physician educationefforts could significantly reduce product sales.**

 

It is important to the success of our sales efforts to educatephysicians in the techniques of using our products. We rely on physicians tospend their time and money to attend pre-sale educational sessions. Positiveresults using the Stretta and Secca Systems are highly dependent upon properphysician technique. If physicians use either system improperly, they may haveunsatisfactory patient outcomes or cause patient injury, which may give rise tonegative publicity or lawsuits against us, any of which could have a materialadverse effect on our sales and profitability. 

 

**We face competition from more establishedGERD treatments and from competitors with greater resources, which will make itdifficult for us to achieve significant market penetration.**

 

Companies that have well-established products, reputations andresources dominate the market for the treatment of GERD. Our primarycompetitors are large medical device manufacturers such as Ethicon Endosurgicaland United States Surgical, manufacturers of instrumentation for anti-refluxsurgery, and C.R. Bard, which manufactures an endoscopic sewing device forGERD. Other large, established companies have products that may, in the future,provide competition for the Stretta procedure. These include injectableproducts for the treatment of GERD, including one developed by BostonScientific, and another developed by Medtronic, the latter of which is still atan experimental stage. Other competitive devices may be developed. 

 

These larger companies enjoy several competitive advantages over us,which may include: 

 

•              Existing anti-reflux surgicalprocedures and devices for the treatment of GERD; 

 

•              Established reputations within thesurgical and gastroenterological community; 

 

•              Established distribution networksthat permit these companies to introduce new products and have such productsaccepted by the physician community promptly; 

 

•              Established relationships withhealth care providers and payers that can be used to facilitate reimbursementfor new treatments; and 

 

•              Greater resources for productdevelopment and sales and marketing. 

 

We do not feel that we compete with large pharmaceutical companies,such as AstraZeneca, Takeda Abbott Pharmaceutical, Wyeth Laboratories andEisai, because candidate patients for Stretta are intolerant to drug therapy orhave failed, or only partially responded to, drug therapy. However, thesecompanies have an established relationship with the gastroenterology communityand generate over $12 billion in annual U.S. revenues from the proton pumpinhibitor drug class. We could be adversely affected if one or more pharmaceuticalcompanies elects to market aggressively against our product, or if a new, moreeffective, pharmaceutical product is developed. For example, AstraZeneca hasdeveloped a new proton pump inhibitor, Nexium, for the treatment of GERD, whichdoctors may prescribe in lieu of recommending the Stretta procedure. Further,less expensive generic drugs have been introduced to treat GERD asAstraZeneca’s patent for Prilosec, the leading prescription medication for thetreatment of GERD, expired in 2001. Prilosec is also now available over thecounter. 

 

**Internationally, we rely on third-partydistributors to sell our products, and we cannot assure you that thesedistributors will commit the necessary resources to effectively market and sellour products.**

 

Internationally, we rely on a network of distributors to sell ourproducts. We depend on these distributors in such markets and we will need toattract additional distributors to grow our business and

 

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expand the territories into which we sell our products. Distributorsmay not commit the necessary resources to market and sell our products to thelevel of our expectations. If current or future distributors do not performadequately, we may not realize expected international revenue growth. 

 

**We depend on the suppliers who provide thematerials and components used in our products, and if we lose our relationshipwith any individual suppliers, we will face regulatory requirements with regardto replacement suppliers that could delay the manufacture of our products.**

 

Third-party suppliers provide materials and components used in ourproducts, some of which are the single and/or sole source for the componentsthey provide. If any of our suppliers become unwilling or unable to supply uswith our requirements, replacement or alternative sources might not be readilyobtainable due to regulatory requirements applicable to our manufacturingoperations. Obtaining components from a new supplier may require a new orsupplemental filing with applicable regulatory authorities and clearance orapproval of the filing before we could resume product sales. This process maytake a substantial period of time, and we cannot assure you that we would beable to obtain the necessary regulatory clearance or approval. This couldcreate supply disruptions that would reduce our product sales and revenue. 

 

**If we, or our suppliers, fail to comply withthe FDA Quality System Regulation, manufacturing operations could be delayedand our business could be harmed.**

 

Our manufacturing processes are required to comply with the QualitySystem Regulation, or QSR, which covers the methods and documentation of thedesign, testing, production, control, quality assurance, labeling, packagingand shipping of our products. The FDA enforces the QSR through inspections. Ourfirst QSR inspection was in March 2001, and we were also inspected inJuly 2003. There were no significant findings from either inspection. Ifwe fail any future QSR inspections, our operations could be disrupted and ourmanufacturing delayed. Failure to take corrective action in response to a QSRinspection could force a shut-down of our manufacturing operations and a recallof our products, which would have a material adverse effect on our productsales, revenues, expected revenues and profitability. Furthermore, we cannotassure you that our key component suppliers are, or will continue to be, incompliance with applicable regulatory requirements, will not encounter anymanufacturing difficulties, or will be able to maintain compliance withregulatory requirements. Any such event could have a material adverse effect onour available inventory and product sales. 

 

**Our failure to obtain or maintain necessaryFDA clearances or approvals could hurt our ability to commercially distributeand market our products in the United States.**

 

Our products are medical devices and are therefore subject to extensiveregulation in the United States and in foreign countries where we intend to dobusiness. Unless an exemption applies, each medical device that we wish tomarket in the United States must first receive either 510(k) clearance orpremarket approval from the FDA. Either process can be lengthy and expensive.The FDA’s 510(k) clearance process usually takes from four to twelve months,but may take longer. The premarket application, or PMA, approval process ismuch more costly, lengthy and uncertain. It generally takes from one to threeyears or even longer. Delays in obtaining regulatory clearance or approval willadversely affect our revenues and profitability. 

 

Although we have obtained 510(k) clearance for both the Stretta System,for use in treating GERD, and the Secca System, for treatment of fecalincontinence in patients who have failed more conservative therapies such asdiet modification and biofeedback, our clearance can be revoked ifpostmarketing data demonstrates safety issues or lack of effectiveness.Moreover, we will need to obtain 510(k) clearance or PMA approval to market anyother new products. We cannot assure you that the FDA will not impose the moreburdensome PMA approval process upon this technology in the future. Moregenerally, we cannot assure you that the FDA will ever grant 510(k) clearanceor premarket approval for

 

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any product we propose to market. If the FDA withdraws or refuses togrant approvals, we will be unable to market such products in the UnitedStates. 

 

**If we market our products for uses that theFDA has not approved, we could be subject to FDA enforcement action.**

 

Our Stretta and Secca Systems are cleared by the FDA, the StrettaSystem for the treatment of GERD and the Secca System for the treatment offecal incontinence in patients who have failed more conservative therapies suchas diet modification and biofeedback. FDA regulations prohibit us frompromoting or advertising either system, or any future cleared or approveddevices, for uses not within the scope of our clearances or approvals, andprohibit us from making unsupported safety and effectiveness claims. Thesedeterminations can be subjective, and the FDA may disagree with our promotionalclaims. If the FDA requires us to revise our promotional claims or takesenforcement action against us based upon our labeling and promotionalmaterials, our sales could be delayed, our profitability could be harmed and wecould be required to pay significant fines or penalties. 

 

**Modifications to our marketed devices mayrequire new 510(k) clearances or PMA approvals or require us to cease marketingor recall the modified devices until such clearances are obtained.**

 

Any modification to an FDA 510(k)-cleared device that couldsignificantly affect its safety or effectiveness, or that would constitute amajor change in its intended use, requires a new FDA 510(k) clearance or,possibly, PMA approval. The FDA requires every manufacturer to make thisdetermination in the first instance, but the FDA can review any such decision.We have modified aspects of our Stretta System, but we believe that new 510(k)clearances are not required. We may modify future products after they havereceived clearance or approval, and, in appropriate circumstances, we maydetermine that new clearance or approval is unnecessary. We cannot assure youthat the FDA would agree with any of our decisions not to seek new clearance orapproval. If the FDA requires us to seek 510(k) clearance or PMA approval forany modification to a previously cleared product, we also may be required tocease marketing or recall the modified device until we obtain such clearance orapproval. Also, in such circumstances, we may be subject to significantregulatory fines or penalties. 

 

**We face risks related to our internationaloperations, including the need to obtain necessary foreign regulatoryapprovals.**

 

To date we have international distribution agreements for Europe, Asia,and South Africa. To successfully market our products internationally, we mustaddress many issues with which we have little or no experience. We have obtainedregulatory clearance to market the Stretta System in the European Union,Australia and Canada and to market the Secca System in the European Union andCanada, but we have not obtained any other international regulatory approvalsfor other markets or products. We cannot assure you that we will be able toobtain or maintain such approvals. Furthermore, although contracts alreadysigned with European distributors specify payment in U.S. dollars, futureinternational sales may be made in currencies other than the U.S. dollar. As aresult, currency fluctuations may impact the demand for our products incountries where the U.S. dollar has increased compared to the local currency.Engaging in international business involves the following additional risks: 

 

•              Export restrictions, tariff andtrade regulations, and foreign tax laws; 

 

•              Customs duties, export quotas orother trade restrictions; 

 

•              Economic or political instability;

 

•              Shipping delays; and 

 

•              Longer payment cycles. 

 

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In addition, contracts may be difficult to enforce and receivablesdifficult to collect through a foreign country’s legal system, and theprotection of intellectual property in foreign countries may be more difficultto enforce. Any of these factors could cause our international sales todecline, which would impact our expected sales and growth rates. 

 

**Product liability suits against us may resultin expensive and time-consuming litigation, payment of substantial damages andan increase in our insurance rates.**

 

The development, manufacture and sale of medical products involves asignificant risk of product liability claims. The use of any of our productsmay expose us to liability claims, which could divert management’s attentionfrom our core business, could be expensive to defend, and could result insubstantial damage awards against us. For example, we are currently a party toa product liability lawsuit where there are allegations that our products aredefectively designed and that we were negligent in manufacturing our products. 

 

We maintain product liability insurance at coverage levels we believeto be commercially acceptable, and we re-evaluate annually whether we need toobtain additional product liability insurance. However there can be noassurance that product liability or other claims will not exceed such insurancecoverage limits or that such insurance will continue to be available on thesame or substantially similar terms, or at all. Our former product liabilityinsurance carrier has filed a civil action against us asking for rescission ofcoverage as it relates to the lawsuit we recently settled for $1.25 million.Any product liabilities claims brought against us, with or without merit, couldincrease our product liability insurance rates or prevent us from securing anycoverage in the future. If the carrier’s suit is successful, we will notrecover any of the settlement amount paid, or any amounts in settlement of anyfuture product liability action arising in the coverage period relating to thisspecific carrier. 

 

**If we fail to take adequate action to remedyproblems that have adversely affected our sales and marketing efforts, ourfuture performance may be harmed.**

 

In the past, we became aware of some issues that negatively impactedour earnings. For example, we learned that it is time consuming to obtainpurchase commitments for our products because of the number of individuals athospitals who need to approve the purchase. As a result, we changed our salesand marketing models to more effectively address this issue. We also becameaware of misinformation in the marketplace regarding past adverse eventsassociated with our procedure. In response, we dedicated resources to educatingphysicians regarding the use of our products to combat this misinformation. Ourefforts to rectify these situations may not be sufficient to materially improveour earnings. In addition, the cost of our efforts in addressing these mattersdiverts resources that could be allocated towards other efforts at increasingrevenues. In the future, we may experience similar problems and if we areunable to take appropriate action, our results of operations and our financialperformance will be harmed.

 

**We have limited protection for ourintellectual property. If our intellectual property does not sufficientlyprotect our products, third parties will be able to compete against us moredirectly and more effectively.**

 

We rely on patent, copyright, trade secret and trademark laws toprotect our products, including our Stretta Catheter, our Secca Handpiece andour Curon Control Module, from being duplicated by competitors. However, theselaws afford only limited protection. Our patent applications and the notices ofallowance we have received may not issue as patents or, if issued, may notissue in a form that will be advantageous to us. Patents we have obtained andmay obtain in the future may be challenged, invalidated or legally circumventedby third parties. We may not be able to prevent the unauthorized disclosure oruse of our technical knowledge or other trade secrets by consultants, vendors,former employees or current employees, despite the existence of nondisclosureand confidentiality agreements and other contractual restrictions. Furthermore,the laws of foreign countries may not protect our intellectual property rightsto the same extent as the laws of the United States. If our intellectualproperty rights do not adequately protect our commercial products, ourcompetitors could develop new products or enhance existing products to competemore directly and effectively with us and harm our product sales and marketposition. 

 

Because, in the United States, patent applications are secret unlessand until issued as patents, or corresponding applications are published inother countries, and because publication of discoveries in the scientific orpatent literature often lags behind actual discoveries, we cannot be certainthat we were the first to file patent applications for such inventions.Litigation or regulatory proceedings, which could result in substantial costand uncertainty, may also be necessary to enforce patent or other intellectualproperty rights or to determine the scope and validity of other parties’proprietary rights. There can be no assurance that we will have the financialresources to defend our patents from infringement or claims of invalidity. 

 

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**Because of our reliance on unique technologyto develop and manufacture innovative products, we depend on our ability tooperate without infringing or misappropriating the proprietary rights ofothers.**

 

There is a substantial amount of litigation over patent and otherintellectual property rights in the medical device industry. Because we rely onunique technology to develop and manufacture innovative products, we areespecially sensitive to the risk of infringing intellectual property rights.While we attempt to ensure that our products do not infringe other parties’patents and proprietary rights, our competitors may assert that our products,and the methods they employ, are covered by patents held by them or invented bythem before they were invented by us. Although we may seek to obtain a licenseor other agreement under a third party’s intellectual property rights to bringan end to certain claims or actions asserted against us, we may not be able toobtain such an agreement on reasonable terms or at all. If we were notsuccessful in obtaining a license or redesigning our products, our productsales and profitability could suffer, and we could be subject to litigation andpotentially substantial damage awards. 

 

Also, one or more of our products may now be inadvertently infringingon existing patents. As the number of competitors in our markets grows, thepossibility of a patent infringement claim against us increases. Whether aproduct infringes a patent involves complex legal and factual issues, thedetermination of which is often uncertain. Infringement and other intellectualproperty claims, with or without merit, can be expensive and time-consuming tolitigate and divert management’s attention from our core business. If we losein this kind of litigation, a court could require us to pay substantial damagesor grant royalties, and prohibit us from using technologies essential to ourproducts. This kind of litigation is expensive to all parties and consumeslarge amounts of management’s time and attention. In addition, because patentapplications can take many years to issue, there may be applications nowpending of which we are unaware and which may later result in issued patentsthat our products may infringe. 

 

**If we lose our rights to intellectualproperty that we have licensed, we may be forced to develop new technology andwe may not be able to develop that technology or may experience delays inmanufacturing as a result.**

 

Our license with Gyrus Group PLC, a public company incorporated andexisting under the laws of England and Wales, allows us to manufacture and sellour products using their radiofrequency generator technology. In addition, theUniversity of Kansas license allows us to apply radiofrequency energy totissue. To the extent these license interests become jeopardized throughtermination or material breach of the license agreements, our operations may beharmed. We may have to develop new technology or license other technology. Wecannot provide any assurance that we will be able to develop such technology orthat other technology will be available for license. Even if such technology isavailable, we may experience delays in our manufacturing as we transition to adifferent technology. 

 

**If we are unable to attract and retainqualified personnel, we will be unable to expand our business.**

 

We believe our future success will depend upon our ability tosuccessfully manage our employees, which includes attracting and retainingengineers and other highly skilled personnel. Our employees are at-willemployees and are not subject to employment contracts. The loss of services ofone or more key employees could materially adversely affect our growth. Inaddition, our stock price is depressed and the results of our operations havebeen less successful than anticipated. This history of performance may make itdifficult to attract and retain qualified personnel. Failure to attract andretain personnel, particularly management and technical personnel, wouldmaterially harm our ability to grow our business rapidly and effectively. 

 

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**Future changes in financial accounting standards or practicesor may cause adverse unexpected fluctuations and affect our reported results ofoperations.**

 

Anychanges requiring that we record compensation expense in the statement ofoperations for employee stock options using the fair value method or changes inexisting taxation rules related to stock options could have a significantnegative effect on our reported results. Several agencies and entities areconsidering, and the Financial Accounting Standards Board (FASB) has announced,proposals to change generally accepted accounting principles in the UnitedStates that, if implemented, would require us to record charges to earnings foremployee stock option grants. This pending requirement would negatively impact ourearnings. In addition, the FASB has proposed a choice of valuation models toestimate the fair value of employee stock options. These models, including theBlack-Scholes option-pricing model, use varying methods and inputs and mayyield significantly different results. If another party asserts that the fairvalues of our employee stock options are misstated, securities class actionlitigation could be brought against us and/or the market price of our commonstock could decline.

 

**Our directors, executive officers andprincipal stockholders have significant voting power and may take actions thatmay not be in the best interests of our other stockholders.**

 

Our officers, directors and principal stockholders holding more than 5%of our common stock together control over 50% of our outstanding common stock.As a result, these stockholders, if they act together, will be able to controlthe management and affairs of our company and all matters requiring stockholderapproval, including the election of directors and approval of significantcorporate transactions. This concentration of ownership may have the effect ofdelaying or preventing a change in control and might adversely affect themarket price of our common stock. This concentration of ownership may not be inthe best interest of our other stockholders. 

 

**Our stockholder rights plan, certificate ofincorporation, bylaws, and Delaware law contain provisions that coulddiscourage a takeover.**

 

In November 2001, we adopted a stockholder rights plan. Thepurpose of the plan is to assure fair value in the event of a futureunsolicited business combination or similar transaction involving us. If anindividual or entity accumulates 15% of our stock, or 20% in the case ofcertain existing stockholders, the rights become exercisable for additionalshares of our common stock or, if followed by a merger or other businesscombination where we do not survive, additional shares of the acquirer’s commonstock. The intent of these rights is to force a potential acquirer to negotiatewith the Board to increase the consideration paid for our stock. The existenceof this plan, however, may deter a potential acquirer, which could negativelyimpact shareholder value. 

 

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In addition, our basic corporate documents and Delaware law containprovisions that might enable our management to resist a takeover. Any of theabove provisions might discourage, delay or prevent a change in the control ofour company or a change in our management. The existence of these provisionscould adversely affect the voting power of holders of common stock and limitthe price that investors might be willing to pay in the future for shares ofour common stock. 

 

**Item3.  Quantitative and Qualitative Disclosures of Market Risk**

 

We invest our excess cashprimarily in U.S. government securities and marketable debt securities offinancial institutions and corporations with strong credit ratings. Theseinstruments have maturities of eighteen months or less when acquired, with anaverage maturity date of at least six months. We do not utilize derivativefinancial instruments, derivative commodity instruments or other market risksensitive instruments, positions or transactions in any material fashion.Accordingly, we believe that while the instruments we hold are subject tochanges in the financial standing of the issuer of such securities, we are notsubject to any material risks arising from changes in interest rates, foreigncurrency exchange rates, commodity prices, equity prices or other marketchanges that affect market risk sensitive instruments. 

 

**Item4.  Controls and Procedures**

 

**(a)****         ****Evaluation of disclosure controls and procedures.**

 

Our management evaluated,with the participation of our Chief Executive Officer and our Chief FinancialOfficer, the effectiveness of our disclosure controls and procedures as of theend of the period covered by this Quarterly Report on Form 10-Q. Based on thisevaluation, our Chief Executive Officer and our Chief Financial Officer haveconcluded that our disclosure controls and procedures are effective to ensurethat information we are required to disclose in reports that we file or submitunder the Securities Exchange Act of 1934 is recorded, processed, summarizedand reported within the time periods specified in Securities and ExchangeCommission rules and forms. 

 

**(b)****         ****Changes in internal controlover financial reporting.**

 

There was no change in ourinternal control over financial reporting that occurred during the periodcovered by this Quarterly Report on Form 10-Q that has materially affected, oris reasonably likely to materially affect, our internal control over financialreporting.

 

## **PARTII    OTHER INFORMATION**

## ** **

**Item1.   Legal Proceedings**

 

In June 2001, a civilaction was filed against us in the United States District Court, WesternDistrict of Kentucky, Louisville Division, in which the plaintiff alleges thathe sustained a nerve injury and damage to his gastrointestinal tract during aStretta Procedure caused by the defective design and manufacture of ourproduct. Plaintiff’s claims against us include strict liability for aproduct  alleged to be in a defectiveand unreasonably dangerous condition, negligence in the design and manufacturingof the product, breach of implied warranty of merchantability, and loss ofconsortium. Plaintiff was a subject in a randomized clinical trial and had beenprovided with an approved Informed Consent form and counseling by thephysician. Prior to treatment, Plaintiff provided consent to proceed. Plaintiffis seeking a trial by jury and unspecified damages. This matter is still in thediscovery, document production and deposition stage.  The trial date has been postponed and is currently scheduled tocommence in February 2005. We believe Plaintiff’s claims are withoutmerit.  The Company believes that theresolution of this matter will not have a material effect, if any, on itsbusiness, financial position, results of operations and cash flows.

 

 

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InJune 2002, a civil action was filed against a number of defendants,including Curon, in the Court of Common Pleas, Philadelphia County, in theState of Pennsylvania, alleging that the plaintiff sustained injury during aclinical trial for the Secca device caused by the device being defective and/orin an unreasonably dangerous condition. We have settled the case, resulting ina payment to Plaintiff in March 2004 of $1.25 million.  This amount had been reserved atDecember 31, 2003.

 

InApril 2003, a civil action was filed against us in United States DistrictCourt for the Northern District of California by Federal Insurance Corporation,our insurance carrier, for rescission, reformation, and restitution inconnection with our liability insurance policy. This policy covers, among otherthings, product liability claims made against us by people treated with ourproduct. There is a summary judgment motion scheduled to be heard July 29,2004 in this matter. Should the Company lose this motion, there will be nocoverage in the Pennsylvania suit described above and the payment of the$1.25 million will be the limit of the Company’s liability in this case.Should the Company win the motion, the $1.25 million may be reimbursed.   If coverage is rescinded, any lawsuits filedarising out of any occurrences between May 22, 2002 and May 21, 2003 would notbe covered by liability insurance.  Weare not aware of any incident occurring in that time period that we believe wouldlead to a lawsuit.  

 

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**Item6.   Exhibits and Reports on Form 8-K******

 

(a)          Exhibits. 

 
| **Exhibit No.** |   | **Description**                                                                                                                                                   |
|-----------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1            |   | Chief Executive Officer’s  Certification Pursuant to 15 U.S.C. Section 7241, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 |
| 31.2            |   | Chief Financial Officer’s  Certification Pursuant to 15 U.S.C. Section 7241, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 |
| 32.1            |   | Certificate of Chief  Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002       |
| 32.2            |   | Certificate of Chief  Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002       |

 

(b)   Reports on Form 8-K. 

 

 During the quarter ended March 31, 2004, we filed thefollowing: a Current Report on Form 8-K dated January 29, 2004, reportingunder Items 7 and 12 the issuance of a press release (Exhibit 99.1 to suchfiling) announcing the results for the quarter ended December 31, 2003;and a Current Report on Form 8-K dated February 6, 2004, reporting underItems 5 and 7 the issuance of a press release (Exhibit 99.1 to such filing)announcing the Securities Purchase Agreement dated February 4, 2004(Exhibit 10.24 to such filing) and the form of warrant to purchase shares ofcommon Stock (Exhibit 4.4 to such filing).

 

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# **CURONMEDICAL, INC.**

# ** **

# **SIGNATURES**

# ** **

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized. 

 
|                | CURON  MEDICAL, INC. |
|---------------------|----------------------|
|                | (Registrant)         |
|                |                 |
| Date:  May 10, 2004 | By:                  | /s/  LARRY C. HEATON II |
|                |                 | **Larry C. Heaton II  President and Chief Executive Officer  (Principal Executive Officer)** |
|                |                 |   |
|                | By:                  | /s/  ALISTAIR F. MCLAREN |
|                |                 | **Alistair F. McLaren  Vice President of Finance  Chief Financial Officer and Chief  Information Officer  (Principal Financial Officer)** |

# ** **

# **26**

# ****